Part 2: Operations and Performance
- 1 Introduction
- 2 Treasury Bond and Treasury Indexed Bond issuance
- 3 Cash management
- 4 Future of the Commonwealth Government Securities Market
- 5 Minimising debt servicing costs subject to acceptable risk
- 6 Residential mortgage-backed securities
- 7 Investor relations
- 8 Public Register of Government Borrowing
- 9 Information technology operations
- 10 Operational risk
- 11 Settlement operations
- 12 Agency financial performance
- 13 Cooperation with other debt managers
The principal functions of the AOFM are:
- funding the Budget through the issuance of Australian Government debt;
- managing the Australian Government’s daily cash balances through short-term borrowings and investments;
- undertaking investments in financial assets in accordance with Government policy objectives;
- managing its portfolio of debt and financial assets in a cost effective manner, subject to acceptable risk; and
- supporting the efficient operation of Australia’s financial system.
This section outlines the activities undertaken in 2010-11 and reports on their performance.
In January 2011 the AOFM was presented with the Sovereign Risk Manager of the Year award by Risk Magazine in London. This is the second time in three years that the AOFM has won this award. It was given in recognition of AOFM’s efficient issuance strategy and residential mortgage-backed securities program undertaken in 2010.
Treasury Bond and Treasury Indexed Bond issuance
One objective of Treasury Bond and Treasury Indexed Bond issuance is to raise monies to fund the Australian Government Budget as it is required from time to time.
Another objective is to support the efficient ongoing operation of Australia’s financial system. This objective is achieved in the following ways:
- Treasury Bonds, Treasury Indexed Bonds, and Treasury Bond futures are used by financial market participants as benchmarks for the pricing of other capital market instruments and to manage interest rate risk; and
- the existence of active and efficient physical and futures markets for sovereign debt strengthens the robustness of the financial system and reduces its vulnerability to shocks.
Achieving the objective
The 2010-11 debt issuance task occurred against the backdrop of concerns about the strength and sustainability of economic recovery in a global context following the global financial crisis. Contributing to these concerns were the further emergence of stresses and falling confidence in European sovereign debt markets; enduring weaknesses in overseas financial sector balance sheets; and the growing realisation that fiscal consolidation across many of the major advanced economies is likely to be increasingly difficult to achieve.
Chart 1 shows the stock of gross Australian Government debt on issue as a proportion of GDP compared with several other OECD countries over recent years.
Source: Treasury, International Monetary Fund 2011 — World Economic Outlook April 2011: Tensions from the Two-Speed Recovery — Unemployment, Commodities, and Capital Flows, World Economic and Financial Surveys, IMF, Washington USA, Table A8 Major Advanced Economies: General Government Fiscal Balances and Debt, p 195.
Australia’s position is very favourable compared to the OECD comparator countries. The AOFM’s debt issuance over recent years is reflected by the increased outstanding stock of CGS as shown in Chart 2.1
Debt issuance was as challenging in 2010-11 as it was the previous year. The size of the issuance program made necessary by the impacts of the global financial crisis required a focus on ensuring a successful uptake of new bond issuance. This involved the AOFM issuing largely in those parts of the yield curve to meet market demand and continuing its direct engagement with investors so as to diversify the investor base while understanding the key considerations for existing investors. The task was also assisted by investors’ perceptions of Australia’s high credit quality, the relative strength of the Australian economy and fiscal outlook, and comparatively attractive yields. These factors resulted in the relatively large volume of issuance in 2010-11 being absorbed smoothly by financial markets. This was important to underpin fiscal certainty for the Government and financial market stability.
Non-resident holdings of Commonwealth Government Securities (CGS) were around 70 per cent of the total outstanding during 2010-11. The proportion of CGS held by offshore investors has fluctuated between just under 50 per cent to just over 70 per cent during the past six years. The low point was at the beginning of 2009-10 and the previous high point was in late 2007-08 just prior to the onset of the global financial crisis.
Gross Treasury Bond issuance for the year totalled approximately $55 billion. The bulk of issuance was into certain existing bond lines in order to enhance their liquidity and attractiveness. This was particularly important to international investors who have been strong supporters of the CGS market.
Four new Treasury Bond lines were launched in 2010-11 as follows:
- A new short-dated bond line maturing in October 2014 was launched to allow issuance to be spread across a larger number of lines and help limit the growth of the largest lines.
- New bond lines maturing in June 2016 and January 2018 were launched to fill in gaps in those parts of the yield curve.
- A new bond line with a maturity date of April 2023 was launched in order to maintain the length of the yield curve and support the operation of the 10-year Treasury Bond futures contract.
During the year it was decided that in future, new Treasury Bond lines will have maturity dates that fall on either 21 January, 21 April, 21 July or 21 October (three of the four Treasury Bonds launched in 2010-11 mature on such dates). These dates coincide with large Commonwealth revenue collections. Aligning maturity dates for Treasury Bonds with these revenue collection dates will facilitate the financing of Treasury Bond maturities.
In selecting the bond lines to issue each week, the AOFM took account of prevailing market conditions; information from financial market contacts concerning investor demand; relative value considerations; the aim of increasing the liquidity of outstanding bond lines; and the need to manage the maturity structure to limit refinancing risk. As in 2009-10, two tenders were held most weeks, typically comprising of a tender for the issue of $500 million of a long-dated bond line and a tender for the issue of $700 million of a short-dated bond line.
Chart 3 shows the Treasury Bonds outstanding as at 30 June 2011 and issuance during the 2010-11 financial year.
During the year the total volume of Treasury Bonds on issue increased by around $37 billion, to $161 billion. At the end of the year there were nine Treasury Bond lines with over $10 billion on issue.
Treasury Indexed Bonds
Treasury Indexed Bond issuance for the year totalled $3.25 billion.
During the year ten tenders for the issue of Treasury Indexed Bonds were conducted. There was also a syndicated offer for the new Treasury Indexed Bond maturing in September 2030.
The volume of each line outstanding, relative yields and other prevailing market conditions were all considered in the selection of which line to offer in any month.
Chart 4 shows the Treasury Indexed Bonds outstanding as at 30 June 2011 and issuance during the 2010-11 financial year.
In April 2009 the Government announced that its investment in NBN Co Limited, the builder and operator of the National Broadband Network, would be partly funded through issuance of Aussie Infrastructure Bonds.
This funding will be through the issuance of CGS as part of the Government’s overall debt program. Aussie Infrastructure Bonds will not be identified separately from other CGS at the time of issue, but will be reported separately in the Budget papers.
The Government’s equity investment in NBN Co Limited in 2010-11 was fully met with funds from the Building Australia Fund; therefore, Aussie Infrastructure Bonds were not required in 2010-11.
Securities Exchange Trading of CGS
On 12 December 2010, the Government announced that it would facilitate the trading of CGS on a retail exchange platform in Australia, as part of its Competitive and Sustainable Banking System package.
The trading of CGS on a securities exchange should provide retail investors with a more visible pricing benchmark for investments they may wish to make in corporate bonds issued by Australian businesses, as well as help to further encourage retail investors to consider diversifying their savings through investments into fixed-income assets, such as government and corporate bonds.
Funding the Budget
The Government‘s budget financing requirement in 2010-11 was fully met.
The budget underlying cash deficit for 2010-11 was higher than estimated at the time of the 2010-11 Australian Government Budget due to lower than expected revenue and the impact natural disasters in early 2011 (as explained in the 2011-12 Australian Government Budget). The larger than expected budget financing task was managed in part by increased issuance of Treasury Notes.
Part of the budget financing requirement in 2010-11 was met by $5 billion of pre-funding undertaken in 2009-10. Most of the proceeds from this pre-funding were invested in short-dated semi-government bonds with maturity dates on or before the maturity dates of Treasury Bonds maturing in 2010-11.
Market liquidity and efficiency
The Treasury Bond market operated smoothly throughout 2010-11 with liquidity being maintained throughout the year.
One measure of liquidity is turnover in the secondary market. Chart 5 shows the evolution of total secondary market turnover2 from July 2008 through to June 2011. As a proportion of total outstanding stock on issue, monthly turnover has consistently remained at around 100 per cent (except for several months during mid 2008-09).
Source: Based on Austraclear data sourced from the RBA.
The Australian Government bond market displayed improved liquidity in 2010-11 with:
- Treasury Bond turnover having increased by 27 per cent in 2010-11 compared to 2009-10;
- Treasury Indexed Bond turnover having increased by 21 per cent in 2010-11 compared to 2009-10; and
- the turnover of 3-year Treasury Bond futures contracts having increased by 29 per cent in 2010-11 compared to 2009-10; and turnover of the 10-year contracts having increased by 35 per cent.
The AOFM’s securities lending facility allows market participants to borrow Treasury Bonds and Treasury Indexed Bonds for short periods when they are not otherwise available. This enhances the efficiency of the market by improving the capacity of intermediaries to make two-way prices. More settled market conditions resulted in less use of the securities lending facility in 2010-11 compared with the previous year. The facility was used 47 times for overnight borrowing in 2010-11 compared with 60 instances of use in 2009-10. The face value amount lent was around $1.3 billion compared to $2.4 billion in 2009-10.
All Treasury Bond futures contract close-outs in 2010-11 occurred smoothly.
Efficiency of issuance
Issuance of Commonwealth Government Securities in 2010-11 was by competitive tender, apart from the syndicated offering of the new 2030 Treasury Indexed Bond.
Tenders held during 2010-11 were well supported. Table 1 summarises the results of Treasury Bond tenders conducted during the year. The results are shown as averages for each half-year and grouped by the maturity dates of the bonds offered.
|Period||Maturity||Face value amount allocated ($m)||Weighted average issue yield (%)||Average spread to secondary market yield (basis points)||Average times covered|
|July-December 2010||Up to 2016||16,500||4.8820||-0.18||3.61|
|January-June 2011||Up to 2016||15,300||5.1104||-0.29||4.38|
The average ratio of the volume of bids received to the amount of stock on offer was 3.91 for Treasury Bonds in 2010-11, a slight increase on the averages for previous years. This was a good outcome given the relatively large volume of issuance in 2010-11. Only one tender had a coverage ratio less than two.3
The strength of bidding at tenders was also reflected in the issue yield spreads to the secondary market. At many Treasury Bond tenders, the weighted average issue yields obtained were below prevailing secondary market yields. The average spreads obtained on Treasury Bond tenders during the year were lower than those in recent years.
The average ratio of the volume of bids received to the amount of stock on offer was 4.13 for Treasury Indexed Bonds in 2010-11, broadly in line with averages for previous years. At five of the ten tenders the weighted average issue yields were below prevailing secondary market yields.
Full tender details are given in Part 5 of this annual report for Treasury Bonds and Treasury Indexed Bonds.
The AOFM manages the daily cash balances of the Australian Government in the Official Public Account (OPA).4 The AOFM’s primary objective in managing these balances is to ensure that the Government is able to meet its financial obligations as and when they fall due. Other objectives are to minimise the cost of funding the balances and to invest excess balances efficiently. In minimising cost the AOFM seeks to avoid undue use of the overdraft facility provided by the RBA.5
Achieving the objective
Achieving the cash management objective involves undertaking appropriate short-term investments and debt issuance.
Cash balances not required immediately were invested outside the OPA for nominated periods of time, with the maturity dates set to coincide with financing large outlays. The types, magnitudes and tenors of the short-term investments were determined by the AOFM. Depending on market conditions and the duration, investments can be made in term deposits at the RBA, negotiable certificates of deposit issued by highly-rated Authorised Deposit-taking Institutions (ADIs), and short-dated bonds issued by Australian State and Territory governments (semi-government bonds). Investment outside the RBA is not risk-free and therefore requires an appropriately higher rate of return.
- Interest rates for term deposits at the RBA are based on Overnight Indexed Swap rates.
- Interest rates for negotiable certificates of deposit and semi-government bonds reflect prevailing market rates for those instruments.
Borrowing to support the cash management task is undertaken by the issue of Treasury Notes. At least $10 billion of notes were kept on issue at all times during 2010-11 to maintain a liquid market.
As noted earlier, part of the budget financing requirement in 2010-11 was met by pre-funding undertaken in 2009-10, with the bulk of the proceeds from this pre-funding invested in semi-government bonds that matured 2010-11. In 2010-11 the AOFM undertook repurchase transactions for the first time to borrow for cash management purposes, using the holdings of semi-government bonds as collateral. This proved a successful mechanism for its purpose.
The size and volatility of the within-year funding requirement are indicated by changes in the short-term financial asset holdings managed by the AOFM, after deducting Treasury Notes on issue. Chart 6 shows the movement in the funding requirement in 2010-11.
The objective of meeting the Government’s financial obligations as and when they fall due was met, with the overdraft facility provided by the RBA accessed only once in 2010-11 (on Friday 6 August 2010 for an amount of $626 million, with the facility being cleared on Monday 9 August 2010).
During 2010-11 the AOFM placed 395 term deposits with the RBA. The stock of term deposits fluctuated from a maximum of $23.6 billion in June 2011 to a minimum of $250 million in January 2011.
- The average yield obtained on term deposits during 2010-11 was 4.68 per cent, compared with 3.60 per cent in 2009-10. The increase in average yield reflects the higher average level of interest rates that prevailed during 2010-11.
Investments in negotiable certificates of deposit were undertaken when excess funds were available for investment and there was an appreciably higher return from investing in such instruments compared with placing funds on deposit at the RBA.
The face value amount invested in negotiable certificates of deposit peaked at $5.8 billion in August 2010. The average additional return in 2010-11 from investing in negotiable certificates of deposit compared with investing funds on deposit at the RBA was approximately 16 basis points per annum. This is estimated to have generated additional investment earnings in 2010-11 totalling around $2.4 million.
Eighty-four tenders for Treasury Notes were conducted during the year, for the issue of $60.6 billion (in face value terms). The tenders were well supported with an average cover ratio of 5.63. Yields averaged around 17 basis points less than bank bill yields of corresponding maturities. Details are in Part 5 of this report.
The movement in total short-term financial asset holdings managed by the AOFM (OPA cash balance plus term deposits with the RBA and other short-term investments managed by the AOFM), together with the volume of Treasury Notes on issue, during 2010-11 are shown in Chart 7.
In undertaking its cash management activities, the AOFM is required to maintain the 91-day rolling average of the daily OPA cash balance within operational limits around a target level. In 2010-11 these limits were the same as applied in 2009-10, with an operational target of $750 million and upper and lower limits of $1,000 million and $500 million respectively. There is also a Ministerially approved upper limit of $1.5 billion.
The 91-day moving average OPA cash balance was maintained within operational limits, and within the Ministerial limit, throughout the year.
Movements in the 91-day rolling average OPA cash balance over the year are shown in Chart 8.
Future of the Commonwealth Government Securities Market
In light of the experiences arising from the global financial crisis, an anticipated return to budget surplus in coming years, new global bank liquidity requirements, and market expectations regarding the amount of future outstanding stock of CGS, the Government consulted a panel of financial market participants and financial regulators on issues impacting a policy decision on the future of the CGS market.6 The review was discussed in the 2011-12 Australian Government Budget.
The panel, which was chaired by the Treasury, noted that the global financial crisis had affirmed the value in maintaining a liquid CGS market of sufficient size to support the long term stability of the financial markets and to ensure the Government is well placed to respond to sudden events that cause large fiscal impacts. It was also noted that there had been an increased allocation into Australian dollar denominated securities by international investors, and that new global bank liquidity standards for banks, agreed by the Basel Committee for Banking Supervision in December 2010, will mean that Australian banks tend to hold larger amounts of CGS on their balance sheets than has previously been the case.
The Government indicated that a primary objective will continue to be maintaining liquidity in the CGS market to support the three- and ten- year bond futures market.
In addition, the Government will continue its support of liquidity in the Treasury Indexed Bond market by maintaining around 10 to 15 per cent of the total CGS market in indexed securities. It has also indicated support for the AOFM to lengthen the CGS yield curve incrementally, in a manner consistent with prudent sovereign debt management and market demand.
To maintain a liquid and efficient bond market that supports the three- and ten- year bond futures market and the requirements of the new global bank liquidity standards, the panel proposed that the CGS market be maintained around its current size — that is, around 12 to 14 per cent of GDP over time. The Government is considering this issue taking into account the views of the panel (this was discussed in the 2011-12 Australian Government Budget).
Minimising debt servicing costs subject to acceptable risk
In managing the Government’s debt portfolio, the AOFM seeks to minimise debt servicing costs over the medium-term at an acceptable level of risk, by which is meant an acceptable level of variability in cost outcomes. It also seeks to maintain liquid bond lines to facilitate the issuance of debt at acceptable cost and to manage the refinancing risk that arises when bond lines mature, while also managing the impact of its issuance on the CGS market.
The primary measure used in balancing cost and risk is historic accrual debt servicing cost. This includes interest on physical debt, realised market value gains and losses, capital indexation of inflation-linked debt and the amortisation of any issuance premiums and discounts. However, it does not include unrealised market value gains and losses. Accrual debt servicing cost is the most appropriate measure of cost in circumstances where financial assets and liabilities are intended to be held, or to remain on issue until maturity and there is little likelihood that unrealised market value gains and losses will actually be realised.
Information on unrealised market value gains and losses is useful in circumstances where it is possible that they may be realised in the future. In the AOFM’s financial statements, debt servicing cost outcomes are presented on a ‘fair value‘ basis that include movements in the unrealised market value of physical debt, assets and interest rate derivatives. A comprehensive income format is used that allows revenues and expenses on an historic basis to be distinguished from the effects of unrealised market value fluctuations, that is ‘re-measurements’.
Achieving the objective
The AOFM influences the cost and risk profile of the portfolio primarily through its decision making on the volume, composition and maturity of the debt securities it issues. The selection of bond lines and the size of tenders for instance have a direct bearing on the cost and risk of the overall portfolio. Issuance through CGS continues to serve debt management and market supporting policy objectives and so factors such as the overall maturity structure of the portfolio, market conditions and the relative demand and cost of different bond lines are all considered when issuance decisions are made.
For Treasury Bonds, the AOFM seeks to spread issuance across the yield curve. Typically (but not always) two tenders are undertaken per week, with one in the short to mid part of the curve (for example, one to six years) and the other in the long part of the curve (for example, seven years and beyond). The tenders may be of different sizes, providing flexibility in the maturity profile of the portfolio as it changes in size over time. During 2010-11, the AOFM also modified the mix of long and short bond issuance in response to market conditions from time to time.
Historically, AOFM research has found that debt issued for long periods at fixed rates of interest pays higher interest rates than shorter-term debt, because lenders tend to demand a higher return for having their funds locked away for longer periods. For many years the AOFM obtained savings in debt servicing costs by using interest rate swaps to lower the duration of the debt on its balance sheet (in other words, the AOFM swapped its longer term fixed-rate debt into shorter term floating-rate debt). However, over recent years market yield curves have flattened, which diminished the savings available from this approach. As a result, in 2008 the AOFM concluded that under the circumstances targeting duration by using swaps no longer provided a firm basis for achieving future savings in debt servicing cost. The last swap matured in May 2010.
The AOFM continues to assess how the length of the yield curve and the composition of bond lines impacts portfolio management objectives, but it still does not find a compelling case to target a relatively low duration. On the contrary, recent research has supported the extension to 15 years of the nominal yield curve as indicated in the 2011-12 Australian Government Budget. The results of this research suggest that the risk-reducing benefits of increasing liability duration in line with the issuance strategy of extending the curve are likely to outweigh the costs.
Chart 9 shows the longer term trend in portfolio duration. Following the 2008 decision to discontinue the existing interest rate risk management framework, the duration of the nominal component of the long term debt portfolio rose from 2.5 to 4 as interest rate swaps were unwound, and then stabilised around 4 as a natural consequence of the composition of debt on issue. Moreover, the accumulation by the AOFM of floating rate notes such as residential mortgage-backed securities over recent years has had the consequence of further extending the portfolio duration. The AOFM has remained comfortable with the cost and risk characteristics of the portfolio resulting from the extension of duration associated with issuance decisions and the accumulation of floating rate notes over the past few years.
Maintaining around 10 to 15 per cent of the CGS market in indexed debt is consistent with the AOFM’s portfolio management objectives. Indexed debt currently comprises around 10 per cent of CGS on issue.
Reducing debt servicing cost at an acceptable level of risk
The debt servicing cost7 of gross debt managed by the AOFM in 2010-11 was $9.27 billion. This represented a cost of funds of 5.22 per cent for the period. Table 2 provides further details of the cost outcomes for the combined portfolio by instrument and portfolio for 2009-10 and 2010-11.
Debt servicing costs on gross CGS debt increased by $2.94 billion compared with the previous year. This was largely the result of an increase in the average volume of debt on issue by $53.28 billion to $177.76 billion in 2010-11. The return on gross assets for 2010-11 increased by $52 million to $1.38 billion; this was despite the average book volume falling by $6.26 billion. The increase reflected a combination of factors including higher short-term interest rates in 2010-11 versus the previous year.
Taken together, the net servicing cost of the combined portfolio of debt and assets was $7.90 billion, with an effective yield of 5.19 per cent. The corresponding figures for 2009-10 were $4.96 billion and 5.36 per cent, respectively.
|Interest Expense||Book volume||Effective yield|
|$ million||$ million||per cent per annum|
|Contribution by instrument|
|Treasury Indexed Bonds||(731)||(1,021)||(11,826)||(16,481)||6.18||6.19|
|Repurchase agreements (a)||–||(12)||–||(257)||4.75|
|Foreign loans (b)||(0)||(0)||(6)||(5)||2.98||7.98|
|Gross physical CGS debt||(6,328)||(9,272)||(124,479)||(177,760)||5.08||5.22|
|Interest rate swaps||41||–||–||–|
|Gross CGS debt (after swaps)||(6,287)||(9,272)||(124,479)||(177,760)||5.05||5.22|
|Term deposits with the RBA||647||391||17,996||8,372||3.60||4.68|
|Investments in bank paper||102||96||2,579||1,979||3.97||4.84|
|Term investments (c)||37||123||1,326||2,546||2.80||4.85|
|State Housing Advances||162||158||2,757||2,685||5.89||5.89|
|Net CGS debt||(4,964)||(7,896)||(92,631)||(152,173)||5.36||5.19|
|Contribution by portfolio|
|Long Term Debt Portfolio||(5,900)||(8,547)||(112,707)||(162,423)||5.24||5.26|
|Cash Mangement Portfolio||400||(114)||10,129||(2,440)||3.95||4.67|
|State Housing Portfolio||162||158||2,757||2,685||5.89||5.89|
|Total debt and assets||(4,964)||(7,896)||(92,631)||(152,173)||5.36||5.19|
|Total after re-measurements||(7,737)||(7,571)||(92,631)||(152,173)|
Note: Sub totals and totals are actual sum results, rounded to the nearest million dollars. Effective yields are based on actual results before rounding, rounded to two decimal places.
(a) Repurchase agreements using investments in State and Territory government bonds as collateral.
(b) Interest expense and effective yield on foreign loans incorporates foreign exchange revaluations effects.
(c) Investments in State and Territory government bonds.
(d) Re-measurements refer to unrealised changes in the market valuation of financial assets and liabilities.
Chart 10 sets out the components by instrument of the change in the debt servicing cost of the portfolio, broken down to show contributions from changes in the overall volume of debt and in the composition of the portfolio, and from movements in interest rates, exchange rates and the Consumer Price Index (CPI).
The increase in total debt servicing costs was due predominantly to the significant increase in the volume of Treasury Bonds on issue, which added an extra $2.34 billion to total debt servicing cost in 2010-11 compared to the previous year. Higher volumes of Treasury Notes and Treasury Indexed Bonds, combined with fewer term deposits being on issue through the year were also factors contributing to rising total debt servicing costs in 2010-11.
The main offset or savings relative to 2009-10 came from RMBS and term investments. Higher RMBS investment balances contributed an extra $233 million in interest revenue during 2010-11 compared to the previous year. Term investments comprised of short-dated semi-government bond holdings generated an additional $86 million in revenue from 2009-10 to 2010-11.
As shown in Chart 11, nominal interest rates had differing effects on the portfolio with the yield curve on average considerably flatter in 2010-11 because of higher short-term interest rates and generally lower longer term rates. Specifically, total interest costs associated with Treasury Notes increased by $183 million while interest earnings on short-term investments (term deposits, term investments and bank paper) increased by $134 million due to higher short-term interest rates. Lower longer term interest rates contributed to a $62 million reduction in interest costs on Treasury Bonds.
Note: One, three and six month average rates in the chart are average Treasury Note yields. Average CGS yields have been presented only for bond lines that were on issue for the entirety of 2009-10 and 2010-11.
Key influences on yield curve movements during this period include the anchoring of short-term interest rate expectations around 4.75 per cent and investors’ flight to quality to safe investments like CGS as a result of the heightened uncertainty in global financial markets.
With regard to the other determinants of the change in total debt service cost, there was an increase in cost of around $74 million attributable to Treasury Indexed Bonds. This stemmed from the impact of consumer price index changes on the capital value of Treasury Indexed Bonds compared to the prior year. Purchases of bank paper had an insignificant effect on the year-on-year change in debt servicing costs, as did the components of the portfolio that are in the process of being run down (the state housing advances and foreign currency debt). Finally, as mentioned above, no new interest rate swaps have been entered into by the AOFM since 16 November 2007, and the only changes in debt servicing cost arising from swaps occurred as a result of the gains made in 2009-10 not having been replicated.
Movements in market interest rates had a moderately favourable impact on the market value of the portfolio in 2010-11, with unrealised gains from re-measurements amounting to $326 million. This was comprised of unrealised gains of $466 million on nominal debt, partially offset by unrealised losses of $132 million on indexed debt and $8 million on RMBS investments.8
In summary, a significant increase in the volume of debt generated a larger net interest cost in 2010-11 in dollar terms. However, the effective cost of funds on the gross debt portfolio remained quite steady in percentage terms. Moreover, increases of 72 and 87 basis points in the returns on short-term asset balances and RMBS to 4.67 per cent and 6.07 per cent, respectively, resulted from higher short-term interest rates. These returns further offset the interest cost on the portfolio. Thus, in percentage terms, the yield on the overall net debt portfolio managed by the AOFM fell by 17 basis points to 5.19 per cent in 2010-11.
Residential mortgage-backed securities
The Australian residential mortgage-backed securities (RMBS) market provides an important source of funding for smaller mortgage lenders. The global financial crisis that started in 2007-08 reduced the availability of funding through the Australian RMBS market, which in turn limited mortgage lenders’ access to funding. In particular, RMBS margins widened to a point that rendered securitisation uncompetitive as a source of finance for lenders. This deterioration occurred despite the high quality of Australian RMBS and the fact that there has never been a credit-related loss on a rated prime Australian RMBS. While conditions and investor sentiment improved in the Australian RMBS market through 2008-09 and 2009-10, the market continued to be affected by the fallout from the crisis and constrained lenders’ ability to offer competitive mortgage products.
In view of these developments, the Government decided to invest in Australian RMBS to support competition in lending for housing during the market dislocation. In October 2008 the Treasurer directed the AOFM to invest up to $8 billion in eligible RMBS, of which up to $4 billion was to be invested in deals with sponsors that were not ADIs. In November 2009 the Treasurer extended the program by directing the AOFM to invest up to a further $8 billion in RMBS, together with $246 million remaining from the initial program. This Direction also extended the objectives of the program to include supporting small business lending, through broadening the potential use of funds raised under the program.
In December 2010 the Treasurer announced, as part of the Competitive and Sustainable Banking System package, a further extension of the program. The subsequent Direction, issued in April 2011, directed the AOFM to invest up to an additional $4 billion and thus a cumulative total of up to $20 billion in RMBS. It also identified the need to encourage a transition towards a market that is not reliant on Government support.
Achieving the objective
RMBS market conditions and developments in the program
In 2010-11, the AOFM agreed to support 21 RMBS transactions from 14 issuers, investing just under $4.35 billion. Since inception of the program the AOFM has invested around $13.37 billion across 49 transactions from 19 issuers.
Throughout the year, the AOFM continued to invest via the two investment channels established the previous financial year, namely the serial (or ‘pipeline’) approach and the reverse enquiry channel.9 While the former ended in December 2010, the latter approach continues to be utilised and is now the only investment channel.
Market conditions have continued to improve during the year. Having said that, the Australian RMBS market continued to face challenges consistent with global credit markets. The improvement in RMBS sentiment over the course of 2010-11 brought an overall increase in the level of private sector participation in primary issuance. Furthermore, the improvement in conditions extended to pricing in both the primary and secondary markets. Primary supply also picked up and 2010-11 saw the return of three of the largest Australian banks to the RMBS market, as well as the completion of a number of other transactions without the support of the AOFM.
Chart 12 shows the participation of AOFM and other investors in RMBS issues since the inception of the program. Participation from other investors averaged 23 per cent from inception until the end of June 2009, while throughout 2009-10 and 2010-11 it averaged over 81 per cent. In the first six months of calendar year 2011, this proportion rose to around 93 per cent of total market activity.10
While the volume of transactions supported by the AOFM rose to over $14.7 billion in 2010-11 from around $9.1 billion the year before, there was also an increase in the volume of transactions that were not supported by the AOFM to just under $9 billion from $5.9 billion. This brings total public RMBS activity to $23.7 billion in 2010-11, from around $15.1 billion the year before. Notably, in the first half of calendar year 2011 there was significant issuance from larger Australian banks and their subsidiaries, as pricing levels moved into line with other sources of funding. As a result of these developments, the volume of Australian RMBS outstanding stabilised during 2010-11 at around $80 billion. The share of housing credit funded by securitisation also showed signs of levelling out during 2010-11 at just below 10 per cent, according to the June 2011 RBA Bulletin.
During 2010-11 investor demand returned for RMBS with longer weighted average lives of up to three years. Commensurate with this improvement in demand, the margin on a AAA rated senior tranche with a weighted average life of around three years improved, falling from around 130 basis points or higher over the bank bill rate at the start of the financial year, to around 100 basis points over the bank bill rate by the end of the financial year.
The return of demand for longer maturities has resulted in new transaction structures shifting away from the style supported by the AOFM throughout much of 2010, which sought to attract bank balance sheet demand for shorter life tranches, towards more traditional structures.
In the first half of 2011, the AOFM was asked to purchase some relatively small longer dated tranches, so as to facilitate the creation of RMBS securities with a weighted average life of around three years. This aimed to meet investor demand for this type of paper. Had the AOFM not been prepared to do so, falling prepayment rates would have given rise to the traditional structure having a weighted average life of closer to four years, ruling out some investor appetite in the process.
The AOFM also supported a number of innovative structures designed to facilitate engagement with new investors and previous RMBS investors who have been disengaged since the global financial crisis. For example, the AOFM has been prepared to purchase tranches with a greater degree of sensitivity to mortgage prepayment rates so as to facilitate the creation of both bullet securities and scheduled amortisation tranches. These innovative structures have enabled issuers to tap new sources of domestic and overseas demand.
The funds raised by the RMBS issues supported by the AOFM have provided an important component of total lending for housing and small business since the inception of the program. Without this funding, new lending by financial institutions other than the major banks would have been lower and their ability to provide competition to the major banks, now and in the future, would have been curtailed. Together, the broad based improvement in market conditions and prices in RMBS markets over the past year, the substantial increase in participation by investors other than the AOFM, and the maintenance of origination capacity of smaller financial institutions and mortgage originators reliant on securitisation, all suggest that the RMBS program has been one of several positive contributors to mortgage competition in the last year.
The investments made under the program are also providing reasonable financial returns. Interest income in 2010-11 was $607 million, which represented an annualised return of 6.07 per cent on the average portfolio book value of $10.005 billion. This compares favourably with the AOFM’s funding costs, detailed in Table 2. All the securities purchased under the program have been floating-rate notes, paying a weighted average margin of just under 130 basis points over the one month bank bill rate as at 30 June 2011. In addition, capital repayments of $2.5 billion have been received.11
The RMBS securities that the AOFM holds are valued in its accounts using indicative margins for secondary market trading as estimated by an independent valuation service provider. As secondary market margins have typically been higher than the margins set on issuance, the estimated market value of these securities has been less than their accrual book value. Despite continued pricing improvements through the narrowing of spreads over the course of 2010-11, the RMBS portfolio had an unrealised loss of $80.8 million (or 0.81 per cent of the portfolio book value) as at 30 June 2011.12 Losses or gains in the mark-to-market value of the portfolio change with prevailing conditions and therefore vary at any particular point in time. They are not ‘realised’ losses or gains.
Further information on the AOFM’s investments in RMBS up to 30 June 2011 is given in Part 5 of this annual report.
The Investor Relations Unit has been working to raise the profile of CGS among institutional investors through promotional and educational activities. Efforts have focused on the continued diversification of the investor base. This is an important step towards maintaining a liquid and orderly market, which will in turn contribute to lowering the costs of government borrowing through higher demand for CGS.
Achieving the objective
Maintaining regular direct contact with current and potential investors has been the primary engagement strategy for the AOFM. This has been done through face-to-face meetings, speaking engagements and presentations. Follow-up contact was made after all meetings and investor details were added into the client relationship management database.
A secondary, but growing, focus has been on developing communications with investors through other mediums. This has involved establishing a new dedicated section for investors on the AOFM website, regular investor updates and research pieces via email and initiating the development of print and digital advertisements for placement in financial publications in 2011-12.
During 2010-11 AOFM officers conducted a large number of bilateral meetings, speaking engagements and presentations as summarised in Table 3. Most of the meetings were arranged with the assistance of the CGS market making financial intermediaries. The AOFM continues to be grateful for their support.
Many of the meetings were with investors who are regularly investing in CGS and so feedback from this group is helpful in understanding issues about the state of the market. The AOFM also met with a number of new and potential investors.
The new investor relations webpage was created within the guidelines pertaining to the provision of information disclosing credit ratings in Australia13 and released under a Creative Commons ‘BY’ licence as required by IP Principle 11(b) of the updated Statement of IP Principles (released in October 2010).
The AOFM also undertook the creative development of a small targeted advertising campaign this year. A full page print advertisement will appear in three monthly editions and the annual edition of the Bloomberg Markets magazine in 2011-12 and a digital banner will be displayed on all Bloomberg terminals over seven days. The advertising campaign was scheduled to coincide with an AOFM investor roadshow to the United States and presentation at a New York Euromoney Conference to target investors in Australian dollar securities.
|Conferences and speaking engagements||9 events|
|Approximate total audience size||850-950 attendees (comprising of approximately 66% investors)|
|Individual meetings||82 meetings|
|Individual cities visited||27 coties (some were visited more than once): Europe 10, North America 2, South/Central America 3, Asia 8, Australia 3, Middle East 1|
|Two AOFM staff members would travel on each trip||CEO, Head of Investor Relations, Director of Financial Risk, or Investor Relations’ Senior Analyst|
|Provided assistance to the Treasurer||Input into 2 presentations. The Treasurer presented to investors in New York and London|
|Banks used to organise investor meetings||ANZ, Bank of America Merrill Lynch, Citi, Commonwealth Bank of Australia, Deutsche Bank, JP Morgan, Royal Bank of Canada, Royal Bank of Scotland, UBS, Westpac.|
Public Register of Government Borrowing
The Guarantee of State and Territory Borrowing Appropriation Act 2009 requires the AOFM to establish and publish a register recording the beneficial ownership, by country, of all Commonwealth Government Securities (CGS) and any Australian State or Territory government securities guaranteed by the Commonwealth.
The Act does not contain any mechanisms to compel the provision of information to the AOFM by the beneficial owners of these securities or persons holding these securities on their behalf. In the absence of a legal or regulatory compulsion to do so, nominee and custodial services firms have not provided information to the AOFM due to their fiduciary and contractual obligations to their clients. Many investors wish for their holdings to remain confidential for valid commercial and other reasons.
This has severely limited the information available to the AOFM to form an opinion on the extent of beneficial ownership of the securities. Without information on the country of beneficial ownership information on the holdings of nominee/custodial firms alone provides a very limited indicator of ‘offshore’ CGS ownership.
During 2010-11, the AOFM published the register each quarter and following the latest update the register contains monthly data up to 30 June 2011. The register indicates that around $231.0 billion of CGS, together with State and Territory securities guaranteed by the Commonwealth, were on issue at year end. Country of ownership could be identified for $87.2 billion or 37.7 per cent, of which $53.3 billion was identified as Australian and $33.9 billion was offshore. Country of beneficial ownership could not be identified for around $143.8 billion or 62.3 per cent. Most of this unidentified component was held by nominee/custodial firms.
The Australian Bureau of Statistics (ABS) also collects and publishes information on the holdings of securities. The legal powers provided to the Australian Statistician enable the ABS to obtain information from nominee/custodial firms on security holdings, however, there are also set confidentiality requirements that can constrain how and to what extent the ABS publishes at a detailed country level.
The quarterly ABS publication 5302.0 Balance of Payments and International Investment Position, Australia indicates that around 70.8 per cent of Commonwealth Government Securities were held by non-residents as at 30 June 2011.14
The annual ABS publication 5352.0 International Investment Position, Australia provides information on the country of domicile for portfolio investment in debt securities. This information covers a broader range of debt securities, issued in Australia and overseas, than that covered by the AOFM register (that is, State and Territory securities not guaranteed by the Commonwealth, as well as, debt securities issued by financial intermediaries such as banks and those issued by companies).
The publication estimates that there was around $766.1 billion of this foreign portfolio investment in debt securities at 31 December 2010. The survey indicated the country of domicile breakdown as: the United Kingdom, $182.6 billion; United States, $168.1 billion; Japan, $54.1 billion; Luxembourg, $13.3 billion; Switzerland, $10.1 billion; China15, $9.3 billion; New Zealand, $4.2 billion; Netherlands, $4.2 billion; unspecified European Union, $3.4 billion; Singapore, $2.3 billion; Bermuda, $1.1 billion; and France, $1.1 billion. The remainder of holdings were attributed to international bond markets, were unspecified, or were not published for confidentiality reasons.
Information technology operations
The AOFM’s operations are highly dependent on its treasury system, which is used to support debt and financial asset deal capture, portfolio management and reporting, settlements, accounting and compliance activities. In September 2010, the AOFM negotiated an extension of the licence for its current system, Avantgard Quantum/Risk. This extension will cover the period from April 2012 to April 2014.
During 2009-10 the AOFM commenced an open market testing and procurement process to identify a treasury system to replace the existing system. There are a number of systems to choose from, all offer different functionality, costs and support arrangements. Given the central importance of the treasury system to AOFM’s operations, the agency has committed significant resources to the due diligence assessment of the fit of prospective treasury systems to meet AOFM requirements during 2010-11.
The AOFM requested Expressions of Interest (EOI) to provide a treasury system through the Government’s tendering system AusTender in June 2010. Five vendors were subsequently short-listed and invited to participate in a closed Request for Tender (RFT) process in December 2010. Following an evaluation of the tenders and demonstrations two vendors were selected in April 2011 to proceed to a solution proof of concept testing stage.
The next steps will require AOFM to use the evaluation outcomes to select a preferred vendor and complete contract negotiations.
Operational risk is the risk of loss due to operational failures resulting from internal processes, people, systems, or from external events. It encompasses risks such as fraud risk, settlement risk, accounting risk, personnel risk and reputation risk.
The AOFM aims to manage its exposure to operational risk to acceptably minimum levels. It maintains a culture of prudence awareness, together with high ethical standards, which are reinforced by adherence to the Australian Public Service Code of Conduct and the Australian Financial Markets Association (AFMA) Code of Conduct. The Compliance Unit monitors compliance with detailed controls and procedures, while the Operational Risk and Compliance Committee and the Audit Committee provide oversight.
Operational risk activities undertaken in 2010-11 included:
- internal audits of controls and monitoring of RMBS investment portfolio, IT Controls and Compliance Risk Framework review;
- preparation of the Certificate of Compliance for the AOFM’s compliance with the financial management framework under the Financial Management and Accountability Act 1997; and
- a review of the AOFM’s Chief Executive Instructions and internal financial delegations issued under the Financial Management and Accountability Act 1997.
The AOFM is a low transaction volume, high transaction value environment. In 2010-11, it settled around $90.8 billion of payments of interest, principal and redemptions on CGS and around $296.1 billion in financial asset acquisitions, including term deposits with the Reserve Bank of Australia, money market, fixed interest and residential mortgage-backed securities. The AOFM also ensures that administered receipts are settled promptly and correctly by its transaction counterparties.
In 2010-11, the AOFM was not late in settling any payment obligations. There were no instances where compensation was sought from a counterparty because of it failing to settle a payment obligation in line with its contractual obligations.
Agency financial performance
The AOFM recorded an operating surplus on agency activities of $5.17 million for 2010-11 financial year, comprising total revenue of $16.96 million and expenses of $11.79 million. The surplus in 2010-11 was due largely to the AOFM reallocating future years’ outputs appropriations into 2010-11 to meet the costs of a syndicated issuance of Treasury Indexed Bonds. The volume of issuance was less than anticipated and so in consequence so too were the costs of syndication.
As at 30 June 2011, the AOFM was in a sound net worth and liquidity position, reporting net assets of $18.08 million, represented by assets of $20.05 million and liabilities of $1.97 million.
As at 30 June 2011, the AOFM had cash and unspent appropriations totalling $18.77 million. These funds are held to settle liabilities as and when they fall due and for future asset replacements and improvements.
Cooperation with other debt managers
The AOFM supports the debt management activities of the Papua New Guinea and the Solomon Islands governments under the Strongim Gavman Program and the Regional Assistance Mission to the Solomon Islands. One staff member is seconded to each of these countries to help develop cash and debt management capabilities. Officials of the debt management agencies of the three countries, including the seconded AOFM staff, met in Honiara in August 2010 to discuss their experience with debt management over the year and the development of management capabilities.
In March 2011, a representative of the AOFM spoke at the Asian Development Bank’s Second Asian Regional Public Debt Management Forum.
During the year the AOFM also hosted visits by officials from China, Indonesia and Papua New Guinea. The AOFM also met with delegates travelling to Australia under the auspices of the Pacific Financial Technical Assistance Centre.
- Bonds include Treasury Bonds and Treasury Indexed Bonds, with forecast and projection amounts consistent with the 2011-12 Australian Government Budget – Budget Paper No.1. ↩
- Total turnover includes repurchase transactions based on Austraclear data sourced from the RBA. ↩
- This occurred on 7 July 2010 in connection with the issue of a new 2016 Treasury Bond. As is always the case for the launch of a new Treasury Bond, a larger than normal amount was offered for sale at this tender, which contributed to the low coverage ratio. ↩
- The Official Public Account (OPA) is the collective term for the Core Bank Accounts maintained at the RBA for Australian Government cash balance management. ↩
- The overdraft facility is more costly than equivalent short-term borrowing (for example, issuance of Treasury Notes). The terms of the facility provide that it is to cover only temporary shortfalls of cash and is to be used infrequently and, in general, only to cover unexpected events. ↩
- The panel consisted of representatives from the AOFM, the Treasury, the Reserve Bank of Australia, the Australian Prudential Regulation Authority, the NSW Treasury Corporation, the Treasury Corporation of Victoria, and a number of private sector financial market participants. ↩
- Debt servicing cost includes net interest expenses (measured on an accruals basis) plus foreign exchange revaluation gains and losses (now minimal). Unrealised changes in the market valuation of domestic debt and derivatives are not part of this measure. ↩
- To put these numbers in context, the market value sensitivity of the net debt portfolio managed by the AOFM to a one basis point interest rate movement as at 30 June 2011 was $84.7 million, with nominal bonds alone comprising $68.1 million per basis point and indexed debt $16.5 million per basis point. ↩
- These channels were described in detail in the 2009-10 Annual Report. ↩
- Excluding transactions not supported by the AOFM reduces this proportion to 81 per cent. ↩
- Additionally, the AOFM sold RMBS investments with a face value of $73.79 million in March 2010 for portfolio management purposes. It announced the details of this sale shortly after its completion. ↩
- The AOFM uses market bid rates for revaluation purposes supplied by a third party revaluation service provider. ↩
- Australian Securities & Investments Commission 2010, Information Sheet 99: Disclosure of credit ratings in Australia, sourced from http:www.asic.gov.au. ↩
- Note this does not cover Commonwealth guaranteed securities issued by the State and Territory governments under the Act. ↩
- Including Hong Kong. ↩
Last updated: 14 February 2014